Last Updated on November 7, 2023 by BFSLTeam BFSLTeam
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Understanding Option Price and Volatility
In options trading, it’s essential for traders to be well-versed in the multitude of factors and variables that influence the pricing of option contracts. There are seven critical variables that exert an impact on an option’s price.
Out of these seven variables, six are characterised by fixed values integral to the option pricing model, while one stands as an estimated variable: volatility. These pivotal variables encompass:
1. The underlying security’s current price.
2. The type of option – whether it’s a call option or a put option.
3. The remaining time until the option’s expiration.
4. The prevailing risk-free interest rate.
5. Any dividends offered by the underlying asset.
6. The option’s strike price.
7. Volatility, the variable of interest.
Volatility is inherently variable, devoid of a fixed, unchanging value. Implied Volatility (IV) holds substantial sway over option pricing, serving as a predictive measure of the anticipated price volatility of the underlying asset. In essence, when IV is higher, option premiums tend to rise, as they reflect the greater expected price swings. In addition to IV, traders should familiarise themselves with Historic Volatility (HV), which gauges past price volatility over a specific timeframe. However, IV takes precedence in the world of options trading, as it plays a more pertinent role in forecasting future price fluctuations.
Varieties of Options Contracts
Options come in two primary categories:
1. Call Options
Call options are contracts that appreciate in value as the underlying asset’s price increases. When the underlying asset experiences an upswing, the value of call options likewise rises, fostering a positive relationship between the option’s worth and the asset’s price.
2. Put Options
Put options operate inversely; their value increases when the price of the underlying asset decreases. Consequently, put option premiums exhibit an inverse correlation with the underlying asset’s price, offering a hedging mechanism against falling market conditions.
Also Read: Futures Pricing
Option Volatility and Pricing Strategies
Leveraging Implied Volatility (IV), traders can employ diverse strategies. Here are a selection of commonly utilised techniques:
a. Naked Call or Put
Buying or selling naked options is a straightforward approach, although it requires a level of experience to navigate effectively. This tactic involves purchasing or vending options without holding the actual underlying asset. Traders often sell naked put options when they anticipate bullish market sentiment accompanied by a degree of volatility. As the market ascends, the trader capitalises on the increasing premium of the put option. Conversely, when a downturn is expected, a call option can be sold for profit. Nonetheless, it’s crucial to recognize that selling naked options entails unlimited risk, especially during volatile market conditions.
b. Short Strangle and Short Straddle
Short strangles involve selling both call and put options at the same strike price, particularly useful when IV is predicted to decrease near expiration. This strategy allows traders to retain the premiums from both options. In contrast, short straddle strategies revolve around selling call and put options with different strike prices, ensuring that the call option’s strike price exceeds the put options.
Additional Read: What is PE Ratio?
c. Iron Condor
Iron Condor strategies encompass trading out-of-the-money call and put option spreads. These approaches amplify profit potential while mitigating risk compared to short strangles. Within this method, a trader assumes a long position on both a call and put option while establishing short positions on one call and one put option. Notably, all four option contracts must feature distinct strike prices.
d. Ratio Writing
Ratio writing is a trading technique wherein a specified ratio is applied to options being sold and purchased. For instance, a ratio of 2:1 signifies that two options are sold for every option bought. This strategy is designed to profit from the anticipated decrease in IV as expiration approaches.
Calculating Option Prices: The Role of Volatility
Option prices are contingent upon seven factors, with six of these variables being readily available to traders. The seventh factor, volatility, remains as the variable with the potential to significantly influence options pricing. To devise effective option strategies, one must grasp the impact of this elusive element:
1. Type of Options – This choice is made by the trader.
2. Underlying Asset Price – This value is a known quantity.
3. Strike Price – A predetermined decision.
4. Expiration Date – An established date.
5. Risk-Free Interest Rate – A known factor.
6. Dividend on Underlying Asset – Also a known component.
7. Market Volatility (Implied Volatility) – This variable remains the unknown element in the equation.
Hence, the intricate interplay between option volatility and pricing strategies is a frequently discussed and central theme in the realm of options trading. Understanding how implied volatility can sway options pricing is paramount in shaping effective trading strategies.
Also Read: Margin Trading vs Short Selling
Influential Factors in Option Volatility
Option volatility is subject to a range of influences, including:
1. Market Conditions: Factors such as political instability and economic uncertainty contribute to market volatility, driving fluctuations in option prices.
2. Supply and Demand: Elevated demand for a specific option can boost its volatility, while a surplus of available options may lead to reduced volatility.
3. Economic Indicators: The release of earnings reports, economic data, and financial indicators can significantly impact the volatility of options associated with a particular stock or index.
Also Read: Swaps in Derivatives
Common Methods For Assessing Volatility Encompass
Traders keen on developing effective strategies must gauge volatility and understand its determinants. This comprehension allows them to identify opportune moments for profitable option transactions. Common methods for assessing volatility encompass:
- Statistical Models: The utilisation of statistical models, such as the standard deviation, provides a quantitative measure of volatility.
- Implied Volatility: Implied volatility is derived from an option’s current market price, encapsulating the market’s perception of forthcoming volatility.
- Historical Volatility: Historical volatility, based on an asset’s actual prices over a specific timeframe, offers insights into past market volatility trends.
Pricing Strategies
Precise pricing of options holds pivotal importance for traders seeking profitable transactions. Pricing models are instrumental in establishing the fair value of an option, considering several variables including the underlying asset’s price, the strike price, time to expiration, and volatility.
Two prevalent pricing models in options trading are:
1. Black-Scholes Model
This mathematical formula determines the fair option price based on the underlying asset’s value, strike price, expiration period, risk-free interest rate, and volatility. It operates under the assumption of market efficiency and adheres to a log-normal distribution in pricing.
2. Binomial Model
Offering increased flexibility, the binomial model accommodates intricate option structures and considers multiple future scenarios that might influence the option’s value. It is particularly valuable in pricing options tied to assets with more intricate valuation dynamics.
Various aspects, including the underlying asset’s value, the strike price, time to expiration, and volatility, play a role in shaping option prices. Volatility, in particular, serves as a pivotal factor impacting option pricing, given its influence on the probability of option profitability.
When option prices deviate from their fair value – whether overvalued or undervalued – traders can employ diverse pricing strategies to capitalise on market inefficiencies and seize opportunities for profitable trades.
In Summary
Options trading presents an enticing avenue for substantial profits, yet it demands a comprehensive grasp of option volatility, pricing, and the application of advanced trading strategies. Option volatility is a pivotal facet of this domain, necessitating an understanding of the influencing factors and the significance of its measurement.
Pricing strategies, exemplified by the Black-Scholes and binomial models, hold a vital role in determining option prices. These models afford traders diverse approaches to navigating the market’s intricacies. Leveraging advanced strategies like straddles, strangles, and spreads offers traders enhanced flexibility and profit potential. However, it is crucial to meticulously assess one’s risk tolerance and market outlook.
